So if the lender takes your property from you, or do you a short sale, chances are the current value is less than your loan. That means the lender has to forgive part of the debt or may pursue you for the difference.
If they forgive the debt, you have cancellation of debt. And if you have cancellation of debt, you have a taxable event.
The amount of debt that is cancelled is taxable income to you. You report it on your Form 1040 just like any other type of ordinary income. In other words, you never got a check, but you have to pay tax on it.
So, let’s go with the foreclosure or short sale scenario and assume that your lender has forgiven debt. Just as a note, though, don’t assume that the lender is forgiving all debt. In most states, they can pursue you if you’ve refinanced the first loan or for a second mortgage. And depending on your particular state laws, they could wait years to come after you for the amount. Yikes!
Anyway, for purposes of this blog, we’ll assume that the property shortfall is forgiven.
Example: You bought a property for $500,000 with a $450,000 mortgage. It’s foreclosed on and sold for $200,000. The lender forgives the debt of $450,000. You have to pay tax on $250,000 ($450,000 – $200,000).
But don’t panic quite yet. If it’s a rental property, you’re going to have some loss too. Let’s keep it simple and assume that there is no depreciation.
You have effectively sold the property for $200,000. Your basis was $500,000. That means you have a loss of $300,000.
Sell it as a rental property:
Taxable income of $250,000. Loss of $300,000. You end up with a net loss.
That’s all the preamble to the big tax issue: Investment property that has not yet been put in service.
If the property is just sitting there, it’s a capital loss when you lose it, not an active real estate property.
Sell it as an investment property:
Taxable income of $250,000. Capital loss of $3,000. You end up with net income.
USTaxAid Solution: Put the property in service before you walk
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